What offends me about the bill is that it serves to raise the status of those who least deserve it. Start with the name, "Dodd-Frank bill." Will Chris Dodd and Barney Frank go down in history as heroes of this era?

It also greatly raises the status of regulators, despite their strong culpability in the errors leading up to the crisis. In fact, despite the bill's length, most of the regulations have yet to be written. Inevitably, those rules be written to the specifications of the largest banks, because the large-bank mindset will be the only one present in the room. My first prediction is that the biggest long-term consequence of this legislation will be a significant increase in concentration in the U.S. financial industry. My second prediction is that the financial consumer protection agency will turn out to be the financial incumbent protection agency. It will be captured by legacy financial firms, who will use it to outlaw new competing products as unsafe.

On the most important issue of "too big to fail," the legislation does exactly the wrong thing. It gives regulators discretion to use resolution authority to break up at-risk institutions. But the regulators already had that. What they need are hard and fast rules that require them to use resolution authority under well-specified conditions. On a case-by-case basis, it is always is safer to do a bailout, just as on a case-by-case basis it always seems easier to just pay ransom to the kidnapper. Resolution authority that is discretionary is resolution authority that will never be used. And the big banks know it.

[UPDATE: Yves Smith says that size isn't everything. Some banks are so important as broker-dealers in particular markets that they will not be allowed to fail for fear of disrupting those markets.

The problem is that it would take a radical restructuring of the very biggest banks, the critically placed dealer firms, and the most important payment and clearing operations to make a real dent in systemic risk. The officialdom the political lacked the will to do so at the peak of the crisis, and there is no basis for fantasizing that it will suddenly develop more nerve now.

I worry about these highly sophisticated financial mechanisms that enjoy de facto government insurance. My concern is that insurance that is free, or very much under-priced, is going to foster a lot of economically unsound financial practices.]

Comments and Sharing

It gives regulators discretion to use resolution authority to break up at-risk institutions. But the regulators already had that.

Got a citation for that? A raft of finance bloggers supported the bill precisely because the government had no authority to break up risky institutions. It could liquidate insolvent, FDIC insured depository institutions but that was about it.

So, they had the authority to break up Citigroup or B of A. They bailed them out instead. With AIG and Bear Stearns, you could argue that they lacked the legal authority to do a breakup, but they equally lacked the legal authority to do a bailout. Somehow, they managed to get around the legal impediments to doing a bailout.

I worry about these highly sophisticated financial mechanisms that enjoy de facto government insurance. My concern is that insurance that is free, or very much under-priced, is going to foster a lot of economically unsound financial practices

It always struck me as being somewhat counter-intuitive that government supplied financial insurance was "bad", particularly in the case of individual savers. However, the philosopher Jamie Whyte recently published a fine article on this very topic:

So far as I understand, the Treasury can extend all the loans it wishes and hold almost any assets it wishes. Unless you know of some law which would actually restrict this activity, it seems too bold to assert that there is a legal problem with what Treasury did.

And, of course, you agree that the government lacked powers over risky institutions. That it had powers over some but not all was precisely the problem the resolution authority is meant to fix, so pointing the fact out doesn't help your case.

Arnold, the ability to seize a firm's assets and resolve the enterprise does not seem related to the ability to hand a firm a ton of money. Like Hyena, I am waiting for someone to show me where the government had the authority to break up at-risk-but-not-bankrupt institutions that weren't banks.

Certainly bankruptcy could have resolved the investment banks and insurance companies. Certainly the politicians chose to bail out firms that could have been resolved outside of bankruptcy. Your point about politicians' preference for bailouts is a good one.

It's incredibly difficult to liquidate large firms even if you have few arguments about the seniority of debt (which you almost inevitably have). Holders of secured debt must agree and hence all have large incentives to defect against one another at the margins of agreement. Coordination failure amongst bondholders is a severe risk. Worse, this failure can stall the bankruptcy process considerably because courts must respond to motions, sometimes in mechanical ways that must delay the process.

In re General Motors Corp. is a good example precisely because it avoided this problem: the Federal government essentially manhandled bond holders and offered bailouts in exchange for silence. This helps price the value of cooperation between bondholders and it's quite high.

In general, a lot of what circulates through the libertarian economic blogosphere suffers from legal blindspots. It presumes that the law will operate as they wish it to; what actually happens is that the transaction costs are transferred to the court system in the form of delays. Such delays can prove disastrous for markets which await outcomes with bated breath.

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